US Commercial Real Estate Faces Deepening Liquidity Gridlock

With high interest rates locking many out of the commercial real estate market (CRE), private lenders have taken the forefront as the primary source of financing, but their selectivity is exacerbating a liquidity crisis. Banks initially sought to renegotiate terms for maturing CRE debt, opening the door for private lenders to offer rescue financing through mezzanine debt, preferred equity, or fresh common equity, primarily in the office sector but now expanding to multi-family, industrial, and hotel properties. However, these workouts are increasingly challenging for private lenders due to rising debt servicing costs that outpace rental income across various sectors.

Borrowing costs in the CRE market have surged in response to one of the sharpest interest rate hikes in decades, compounded by stricter lending standards after regional bank failures in March and declining office occupancies post-COVID. Private lenders, while thriving in this environment, are treading cautiously, realizing that not every opportunity is viable, especially in cities plagued by crime and dwindling demographics or assets requiring significant investments for rehabilitation. This growing caution among private lenders only worsens the liquidity shortage for property owners with limited exit options.

For property owners, two-year interest rate caps that once shielded against rate hikes are expiring, with new caps now costing tens of millions of dollars, further complicating refinancing. Weaker fundamentals have led to smaller senior refinancing loans at significantly higher rates, making it difficult for borrowers to meet loan obligations while lenders lack the necessary balance sheet capacity.

Selling distressed assets has become increasingly challenging, as a limited pool of buyers demands lower valuations, potentially leaving existing owners with no proceeds after settling their loans. With nearly $2 trillion of CRE debt maturing in the next two years, demand for private liquidity is set to rise, but competition among lenders has dwindled, and many over-leveraged borrowers may struggle to secure financing.

The market’s liquidity gridlock, exacerbated by declining property values and uncertainties in vacant buildings, has left investors uncertain about generating profitable returns. Some experts warn that depending on the property sector, it may take three years or more to witness a recovery cycle, and private lenders may have to downsize their portfolios due to high management costs.

While the delinquency rate for loans in commercial mortgage-backed securities stands at 4.76%, it is expected to approach 10.51% in the coming years, reminiscent of the peak during the global financial crisis, according to Moody’s Analytics. However, experts believe the risk of a systemic crisis is low, with a gradual clearing of oversupplied assets that no longer align with the current economic landscape.